Justified Price-to-Sales ratio

The justified-price-to-sales ratio or justified P/S multiple is the price-to-sales ratio based on the Gordon Growth Model (GGM). Thus, it is the price-to-sales ratio based on the company’s fundamentals. This is different from the price-to-sales (P/S) ratio that is typically reported in financial media, which is based on historical sales and the observed stock price.

On this page, we discuss the justified price-to-sales ratio formula and illustrate how to calculate the ratio using a numerical example. The P/S ratio calculator can be downloaded at the bottom of the page

Justified price-to-sales ratio formula

The formula for the justified P/S ratio is the following

    $$\textrm{P/S ratio} = \frac{\frac{E_1}{S_0}(1-b)\cdot(1+g)}{r-g}$$

where E0 are the earnings, S0 are the sales. The ratio of these two variables is the net profit margin. We see that the profit margin influences the justified P/S directly as well as indirectly. The indirect impact comes from the sustainable growth rate g, which depends on the retention rate b

    $$g = \textrm{retention ratio} \cdot \textrm{net profit margin} \cdot \frac{\textrm{sales}}{ \textrm{assets}} \cdot \frac{\textrm{assets}}{\textrm{shareholders' Eq}} $$

Finally, r is the required rate of return.

Justified P/S interpretation

The formula indicates that the P/S ratio will go up, all else equal, if the profit margin increases and when the earnings growth rate increases. Interestingly, we can rewrite the formula such that the P/S ratio can be calculated using the trailing justified P/E.

    $$\textrm{P/S ratio} = \frac{E_1}{S_0} \cdot [\frac{(1-b) \cdot (1+g)}{r-g}]$$

The second term is the justified trailing P/E ratio.

Justified price-to-sales multiple example

If we have all the relevant data on a company, we can calculate the justified ratio and compare it to the observed P/S ratio. If the observed price-to-sales ratio is higher than the justified P/S ratio, than the stock is overvalued. If the justified price-to-sales is higher than the actual P/S, then the stock is undervalued and an analyst should consider issuing a buy recommendation.

The following table uses the above formula to calculate the justified P/S ratio. The spreadsheet used to create this example can be downloaded below the summary.

Justified-PS-ratio

Summary

We discussed the justified P/S ratio. This measure can easily be calculated using data on the net profit margin and the retention ratio, growth rate and required rate of return.